Even in a low interest rate environment, the reality is that prepaying a mortgage is the equivalent of a ‘guaranteed’ bond return, at a yield that is better than cash and arguably even appealing on a risk-adjusted basis in a world of potentially low equity returns. However, the caveat is that while making mortgage prepayments can have long-term benefits, they’re only very long term benefits – as prepaying a mortgage to reduce the cumulative loan interest and term of the loan may not be felt for a decade or two thereafter.
One alternative to more immediately enjoy the “benefits” of prepaying a mortgage, though, is to request a mortgage recast. By recasting the mortgage – re-amortizing the loan balance over the original term – the borrower enjoys immediate relief in the form of lower future mortgage obligations. Of course, the original mortgage payment can still be made. But at least the borrower has the option to pay less if desired… which can be especially helpful if the household has a financial shock, from unemployment to a medical event or short-term disability.
Unfortunately, though, in today’s mortgage environment, recasting is not easy. Most lenders assess a small but not trivial processing fee every time a recast is requested. And it must actually be manually requested, and then manually approved by the loan servicer, and by the investor if the mortgage has been resold since its origination. In addition, not all types of mortgage loans are even eligible in the first place.
Yet the question arises: what if mortgage recasting were not only easier, but automatic, such that a borrower who makes a prepayment automatically and immediately receives the benefit of a reduced future mortgage obligation? With automatic recasting, mortgage prepayments no longer just produce a long-term (but highly intangible) benefit; it also produces immediately tangible relief, in the form of a reduced mortgage obligation. Which in turn improves the household’s financial flexibility, and can even improve the stability of the overall mortgage market by both reducing default risk (since the mortgage payment obligation is smaller and easier to maintain) and also reducing loss exposure for lenders (as ongoing prepayments build more equity for the borrower, reducing the risk of a lender that is compelled to foreclose on a default).
In fact, ironically the potential positive incentives for automatic recasting may be so significant, that the biggest problem could become the tendency for households to become “house rich and cash poor” by systematically paying off their mortgages in advance. Still, given the difficulty that many consumers have in saving by any means except home equity, and the availability of reverse mortgages, perhaps this would not be such a bad outcome after all?